In many cases where the IRS claims that compensation is not “reasonable,” the focus is on whether the compensation is too high to be deductible by the employer. The arguments are often reversed in the S corporation context. Because there is only one level of tax in the S Corporation, some owners try to minimize the amounts paid to them as wages and maximize the non-wage distributions paid because the wages are subject to employment taxes and the distributions are not. So in its audits of S Corporations, the IRS sometimes finds itself in the position of arguing that the compensation paid to an owner was unreasonably low, particularly in situations where the S Corporation owner is a service professional (e.g., lawyer or accountant) and the revenue of the business is generated in large measure by the owner.
That is the situation of Watson v.United States, a recent Eighth Circuit decision involving an accountant’s S Corporation. In that case, the court held that the IRS could recharacterize dividends paid to the S shareholder as wages and subject those dividends to FICA (Social Security) taxes. In doing so, the Eighth Circuit held for the first time that the concept of “reasonable compensation” applies for FICA tax purposes, as well as for income tax purposes, and that the employer’s intent not to pay wages or salary, but instead to make a non-wage distribution, is not dispositive of whether an amount paid is compensation for tax purposes.
S Corporation owners should keep in mind the requirement that “reasonable compensation” be paid in structuring their compensation arrangements. They should also keep in mind that under qualified retirement plan rules, only the wage payments can be “compensation” for purposes of 401(k) deferrals or other qualified plan contributions. Unreasonably low compensation can also result in low retirement plan benefits.